TI 2011-171/3 Tinbergen Institute Discussion Paper Halal Certification for Financial Products: A Transaction Cost Perspective Raphie Hayata Frank A.G. den Buttera Udo Kockb a VU University Amsterdam, and Tinbergen Institute; b Resident Representative for the West Bank and Gaza, International Monetary Fund. Tinbergen Institute is the graduate school and research institute in economics of Erasmus University Rotterdam, the University of Amsterdam and VU University Amsterdam. More TI discussion papers can be downloaded at http://www.tinbergen.nl Tinbergen Institute has two locations: Tinbergen Institute Amsterdam Gustav Mahlerplein 117 1082 MS Amsterdam The Netherlands Tel.: +31(0)20 525 1600 Tinbergen Institute Rotterdam Burg. Oudlaan 50 3062 PA Rotterdam The Netherlands Tel.: +31(0)10 408 8900 Fax: +31(0)10 408 9031 Duisenberg school of finance is a collaboration of the Dutch financial sector and universities, with the ambition to support innovative research and offer top quality academic education in core areas of finance. DSF research papers can be downloaded at: http://www.dsf.nl/ Duisenberg school of finance Gustav Mahlerplein 117 1082 MS Amsterdam The Netherlands Tel.: +31(0)20 525 8579 Halal Certification for Financial Products: A Transaction Cost Perspective Raphie Hayata, Frank den Butterb and Udo Kockc Abstract Halal certification of financials product may reduce transaction costs for its buyers when it provides a trusted standard for investors that seek to comply with Islamic law. However, we show that in practice it takes considerable amounts of time (20 days ) and money (USD 122,000) to obtain a halal certification. Mainly, this is because the market is very concentrated and forms a closed circuit. About 20 Sharia scholars control more than half the market, of which the top 3 earn an estimated USD 4.5 mln in fees per year. Moreover this market seems plagued by a number of problems, most notably a strong incentive to be excessively lenient in certification, sub-standard governance practices, lack of consensus regarding certification standards and limited knowledge of finance. Therefore it is questionable whether the reduction in transaction costs through halal certification outweighs the costs of certification. Consolidation of the numerous ways halal certification can be obtained and moving halal certification more into the public goods sphere, where a neutral non-profit government induced party should assume the current role of the halal certifiers, may enhance the reputation of certifies and reduce the transaction costs associated with halal certification. Keywords: Islamic finance, quality certification, certifier behaviour, transaction costs, information asymmetries, credence goods JEL codes: L14, L15, D23, D82 a Corresponding author, VU University Amsterdam, Department of Economics, De Boelelaan 1105, 1081 HV, Amsterdam, The Netherlands; email: [email protected] b Professor of Economics, VU University Amsterdam, Department of Economics, De Boelelaan 1105, 1081 HV, Amsterdam, The Netherlands; email: [email protected] c Resident Representative for the West Bank and Gaza, International Monetary Fund; email: [email protected] 1 I. Introduction Standardization and certification are well known methods to reduce transaction costs. From that perspective we look at the economics of certifying financial products as Islamic. Islamic law (Sharia) obligates Muslims to only invest in assets that are halal (permissible according to Islam). However, specific knowledge is needed to assess whether a financial product is in fact halal. Consequently, a market has been created that fulfils this need, the market for halal certification of financial products. This market has some very interesting features with respect to value creation by providing a quality standard. Moreover, as the demand for Islamic financial products increases, research on Islamic banking (e.g. Khan, 2010) and investing (e.g. Hayat and Kraeussl, 2011; Hoepner, Rammal and Rezec, 2011) is also on the rise. However it seems that the market for halal certification obtained very limited attention in the analysis of economics institutions, which is odd, since halal certification is the key feature that separates Islamic from conventional finance. We aim to fill the gap in two ways. First, we describe the market for (financial) halal certificates and the process of getting such a certification. Second, we identify inefficiencies in this process using transaction cost theory and an empirical investigation. From a transaction cost perspective, the market for halal financial products is characterized by large information asymmetries between buyers and sellers. The buyer does not know whether the financial product is in fact halal or not and has to invest time and money in finding this out. Thus, buying a halal financial product is accompanied with high transaction costs. Certification of such products (in theory) has the potential to increase welfare by reducing these transaction costs. However, our analysis reveals that in practice this objective is not achieved and the problem of information asymmetry has just been shifted from one between buyers and sellers to one between sellers and certifiers. Sellers have to make substantial costs and invest time in getting their products certified as halal. Partially, this is because the market is controlled by a select few Sharia scholars, some of whom make an estimated USD 4.5 mln per year in fees for certifying financial products. It seems that institutions of halal certification are still in an early stage of development, and that halal certification has not yet reached the stage, where there are only a few worldwide trusted standards. This latter stage is characteristic for a mature market for certification and standards, which is from the perspective of network externalities in principle a “winner takes all” market. The remainder of the paper is structured as follows: Section II introduces Islamic finance. Section III describes Sharia scholars. Section IV describes a typical certification process. Section V discusses halal certification as a standard and the channels through which it could reduce transaction costs. Based on that analysis Section VI gives some recommendations. Finally section VII concludes and makes suggestions for further research. 2 II. Islamic finance and the basics of halal certificatoin Islamic finance is a broad term used for all financial transactions that are permissible by Islamic law (Sharia)1. The main building blocks are the prohibition of riba (interest), gharar (excessive risk), maysir (gambling) and industries that are considered unethical such as alcohol and pornography. These restrictions imply that Muslims cannot receive or pay interest, they should exactly know the countervalue that is offered in a transaction, they may not speculate and they may not derive profit from unethical industries. It follows that next to investing in conventional bonds, most derivatives and structured products is prohibited. Investment products that comply with Sharia law are called halal, products that do not comply are called haram. Taking entrepreneurial risk to earn profit, however, is allowed. According to Kuran (2004), Islamic finance in its current form began around the partitioning of India and Pakistan as an attempt to strengthen the Muslim identity. It was most notably advocated by the Pakistani scholar Abul Ala Maududi (1903-1979). Arguably the first Islamic bank was incepted in Egypt in 1963 (the Mit Ghamr Islamic Bank). Although initially focused on banking, the industry has branched out over capital markets and insurance as well. Nowadays, there are over 400 Islamic financial institutions operating in 39 countries offering products/services such as banking, equities, mutual funds, insurance and even bonds, so called Sukuks (General Council for Islamic Banks and Financial Institutions, 2009). In terms of size it is a relatively modest market, but it has been growing very fast (15 percent per year) for a number of years (Khan, 2010). Banking assets are estimated to be USD 1 trillion in 2010 (Shanmugam and Zahiri, 2009; Hoepner et al. 2011) and with a potential market of more than a billion Muslims worldwide these assets are expected to continue growing. In order for a financial products to be considered halal, it must be certified as such by experts in Islamic law, called Sharia scholars. Specifically, these scholars should be experts in Fiqh Al Muamalat, which is Islamic commercial law. There are different views however on what is considered halal or not depending on which school of thought the certifying scholar adheres to. To understand the differences in these schools of thought we must first introduce the sources of Islamic law. Shanmugam and Zahari (2009) give a good overview, they indicate that there are major and minor sources of Islamic law. The main two sources are the Quran, which is the holy book of the Muslims and Hadith, which are the reported sayings and actions of the Prophet Mohammed. Whatever is explicitly mentioned in the Quran or Hadith is considered Islamic law. On matters not explicitly discussed herein (and there are many of those) Islamic scholars can debate and if they reach consensus, that consensus becomes law (Ijma). Qiyas is the method of deducting law from analogy. Essentially, it is using a preceding ruling from Islamic law and applying it to cases that contain the same elements addressed by that ruling. Other (minor) ways to derive law are Ijtihad (personal interpretation